Certain narratives periodically dominate investor minds. And this year, one such narrative is that “inflation is coming”. Here are a few thoughts on this topic.
Investment process: If forecasting inflation is not part of your investment process or if you don’t have any evidence that such forecasts added any value, then should you let this narrative affect your portfolio allocations this year?
Our answer is no, although we’ll take a ‘verbal shot’ at it below. There is always some narrative to worry about but does it have a track record of forecasting the future better than a coin toss?
Popularity: When narratives become popular and feel like a ‘no brainer’, it’s usually not a good risk / return trade.
Because the ‘no brainer’ narrative is already priced in, even if it turns out to be correct investors won’t make any excess return from trading on it. If the narrative proves wrong, the prices will move in the opposite direction. Either way, investors don’t win by reacting to a popular narrative.
Unpopular view: If you can find an unpopular idea in contrast to the popular narrative, you have a better chance of earning excess returns. Of course unpopular views are frequently incorrect. But if you do happen to come across a correct and unpopular idea, then the returns will be there.
Looking at the “inflation is coming” narrative today, here is what I keep coming back to:
You can hand out a lot of money to people but if supply responds to the rising demand, there should be no inflation. Will Amazon and Walmart run out of socks and toothpaste even if people have a lot more cash on their hands to spend? And that assumes that people will be buying more socks and toothpaste in the first place instead of saving the extra cash.
Yes, governments printing money has often led to high inflation. But it happened alongside the supply side getting into trouble. Things like WWII or Soviet Union falling apart all caused major challenges with factories / capacity, and when the governments printed money that led to inflation.
As my colleague John Toohey says: “Capitalism is disinflationary” and after decades of productivity growth and globalization of labor and capital, US companies have created tons of excess capacity to handle increased demand if it shows up.
Today, the limited supply is more evident in financial and real assets which have been going up as a response to money creation. Perhaps certain services and goods do have a limited capacity and so we can see some inflation there. But there are many items in the CPI basket such as beverages, cereal and toys that make it hard to imagine an upper limit to their supply.
Here is what’s inside the CPI: “The basket of goods includes basic food and beverages such as cereal, milk, and coffee. It also includes housing costs, bedroom furniture, apparel, transportation expenses, medical care costs, recreational expenses, toys, and the cost of admissions to museums also qualify. Education and communication expenses are included in the basket's contents, and the government also includes other random items such as tobacco, haircuts, and funerals.” Source
Counter view: Supply can be distorted by many factors like regulation, taxes, politics, climate, social unrest, trade or physical wars, over-levered companies going out of business at large scale. In that case the printed money could lead to inflation. Some of these factors can change unexpectedly fast making the “inflation is coming” camp right but for the wrong reason.
In sum, only looking at the increased money supply is tempting but not sufficient to make the case for inflation.